| Abstract: | This paper investigates the claim that the finding of cointegration between commodity spot and lagged futures rates reflects the existence of commodity arbitrage and not, as is generally accepted, long‐run market efficiency. The methodology of Kellard et al. (1999) is employed to match spot and lagged futures rates correctly for the UK wheat futures contract traded at LIFFE. Bi‐variate analysis shows that spot and lagged futures rates are cointegrated with the vector (1, ‐1), a necessary condition for market efficiency. However, at variance with asymptotic theory, in a tri‐variate VECM estimation, the spot rate, lagged futures rate and lagged domestic interest rate are shown to be cointegrated with the vector (1, ?1, 1). The “cointegration” paradox is explained by investigating the relative magnitudes of the forecast error and the domestic interest rate. The small sample results demonstrate that it is impossible to distinguish between the influence of commodity arbitrage and the existence of market efficiency using cointegration‐based tests. In summary, this work implies that such tests are not wholly appropriate for evaluating commodity market efficiency. |
